Options are a great way to generate a consistent income for your portfolio. While there are a few different ways that options can be used to generate income, we will focus on 2 popular income strategies used by investors. When choosing which strategy to use, one must consider what their end goal is, what stocks are already owned and what direction the stock will move in the future. Before learning about these strategies, it is important to understand what time-decay means in the world of options and how this affects income strategies using options as well as how strike selection affects the income received for the seller of an option.

‍

Time Decay (Theta)

Theta refers to the change in the option price with respect to time. As options have an expiration date, options will decay in price as time goes by. Theta tells us the rate at which an options price will decay with time. When buying options, it is best practice to get in and out of the trade as quickly as possible to minimize the effect of time decay eating away at your profits. On the other hand, theta works in favour of the option seller as it is in the seller’s best interest for the option to expire worthless. Furthermore, the speed at which the option price decays with respect to time is not linear. Assuming everything else is constant, weekly options decay more quickly than monthly options as there is less time for the stock to make a big move. This is shown in the graph below where the speed of time decay accelerates closer to expiration. Option sellers would benefit more from selling shorter dated options.

‍

Risk Tolerance and Strike Selection

The goal for option sellers is for the option to expire worthless. However, the closer the strike price is to the current market price of a stock, the more premium is received for the option seller. When choosing a strike price, the option seller should try maximize the premium received while also maximizing the probability of the strike price not being reached (so the option expires worthless). Options that have a low delta and have strike prices that are further away from the current price have a higher chance of expiring worthless, but also pay less premium. Options that have a high delta with closer strikes will pay more premium but will have a lower chance of expiring worthless. Selecting a suitable strike price is dependent on the risk tolerance of the option seller:

‍

Strategy 1 – Selling Covered Calls

A covered call is the most popular way of generating an income through options. There are two steps required for an investor to execute this strategy – owning a minimum of 100 shares of a stock and shorting (selling) an “out of the money” call option. This income strategy is effective when there is a neutral or bearish sentiment on a stock. As the investor is the seller of the option contract, he/she receives an immediate income in the form of the premium paid by the buyer of the contract. 

Deciding on a suitable strike price

An investor selling a covered call would look for an out of the money (OTM) strike price. In the case of selling a call, an OTM strike price would be higher than the current market price of the stock. For example, if AAPL was trading at 170, an investor would want to sell a call option with a strike price at 185. The more OTM the call option is, the less premium would be paid to the seller as there is a lower probability of the stock price reaching the strike price within the life of the contract. Picking a strike price that is close to the current market price of the stock may be tempting as there is a higher premium received, but there is also a higher probability of the stock reaching the strike price during the life of the contract.

Why use a Covered Call instead of a Sell Limit Order?

Consider the following example:

Using the example above, selling a Jan 2019 $185 call @ $3 generates an immediate income of $3 per share (so $300 in total). Assuming the investor bought the shares at $170, the Covered Call strategy would be profitable if the market price of the stock remained above 167 (170 – 3 premium), whereas the sell limit strategy would only be profitable if the stock remains above 170. Another key advantage the Covered Call strategy has in this case is the length of exposure. An investor using the Covered Call strategy only has exposure until the expiration date while the Sell Limit strategy exposes the investor until AAPL reaches $185.

Best Practices for Covered Calls

Selling short term options (3-7 weeks) tend to provide better results. Short term option contracts have an advantage over long term contracts due to earnings cycles. Longer term options are exposed to more earnings releases that causes them to be subject to large price movements.

As mentioned earlier, an investor using a Covered Call strategy would find it beneficial to use an OTM strike price as there is a lower probability of the stock to reach that price. However, OTM strike prices and premium received have an inverse relationship. The selection of a suitable strike price can be optimized by using Delta as Delta represents an approximation of the probability that the stock price will stay below the strike price. Conservative strike prices should be used for selling Covered Calls (15-20 delta)

When it comes to using a Covered Call strategy, the goal is to hold the contract until the expiration date. Therefore, it is important to pick a strike price and expiration that minimizes the risk of the stock reaching that price while maximizing the premium received. In other words, an investor would want the option to expire worthless. Once the option expires worthless, the Covered Call strategy can be repeated, and this generates a consistent stream of income from simply owning the stock.

‍

Strategy 2 – Cash Secured Puts

A Cash Secured Put is simply selling a put option while setting aside cash to buy the stock in the case of assignment. This is slightly different to selling a naked put option where the writer of the put sits and hopes that price does not decline. The Cash Secured Put is primarily considered to be a stock acquisition strategy but can also be an income generating strategy. As this strategy involves receiving a premium for selling a put option, the investor can generate a consistent income with this strategy. However, due to high downside risk, other income generating strategies such as Credit Spreads provide better risk profiles.

This payoff diagram is identical to that of the naked put strategy. The key difference between these two strategies lies in the intention of the investor. A naked put strategy is a cash generating strategy where the investor only wants to profit from the premium received and hopes that the option is not exercised. A Cash Secured Put strategy allows for the shares to be bought using the cash put aside and hopes that the option is exercised as it allows the investor to buy the stock for a lower price.

Why use Cash Secured Puts?

The motivation behind selling Cash Secured Puts is usually to acquire the stock at a lower price than its current price. For example, if FB stock was trading at $100 and an investor shorted 1 FB 90 put for $1 per share, the investor would need to buy the stock in the event that the option is exercised. If the investor shorted a naked put option instead, the above scenario would be seen as a negative outcome as the intention of the investor was to profit from receiving the premium and not having to buy the shares. However, in this case, the intention of the investor using the Cash Secured Put strategy is to acquire shares at a lower price and instead of originally having to buy FB stock at 100, the investor can buy them at 90. This also allows the investor to use the premium received to net the total cost of buying the shares at the strike price. The overall effective cost of buying each share is therefore reduced to $89 (90-1).

This seems like a win-win situation for the investor. If the market price rallies, the investor profits from the premium received and if the price drops, the investor gets to purchase shares cheaper. However, there are situations where this strategy will not work. If the stock price were to plummet to $50 instead of having a short-term retracement, the investor would have a loss of $39 per share. In the worst case, if the stock price declines to zero, the maximum loss for this strategy is $89 per share. It is also important to consider the case of FB stock not retracing and immediately rallying. Although the investor receives a premium and is in a profitable position, the investor loses the opportunity to buy FB stock at 90 and instead would have to consider buying at a higher price.

Buy Limit Order vs. Cash Secured Put

Consider the example below:

In all 3 outcomes, Selling Cash Secured Puts provides a better risk profile to that of a Buy Limit Order.

Best Practices and Tips

There are 2 things to consider before implementing a cash secured put strategy:

• Time to expiration – Due to time decay (Theta), options lose value the closer they get to expiry. Options with shorter expirations lose value quicker to those of further expirations. As this strategy involves selling a put, Theta works in favor of the seller of the contract. The writer of the option should consider short term options (4-7 weeks) to maximize Theta.
• Strike Price – When choosing a strike price, it is better to take a more aggressive approach. As this strategy is a stock acquisition strategy, investors would want the option to be exercised even if they are short the put option. Picking a strike price closer to the current price increases the premium received and decreases the probability of the option expiring worthless. 

This strategy works best for investors looking to acquire the stock at a cheaper price than the current market price. This strategy supports an “short-term bearish but long-term bullish” outlook. By shorting a put and setting aside cash to buy the stock if the put is exercised, investors can take advantage of short term retracements in long term trends of a stock. While the strike price and time to expiration is dependent on the risk tolerance of the investor, short term options with strike prices close to the current price are more ideal for this strategy.

‍

Combining both Strategies to Maximize Capital Appreciation

Combining both strategies mentioned above provides a great way for investors to buy low (using cash secured puts) and sell high (using covered calls) and thus maximizing the capital appreciation of the stock or ETF. This also generates an income while the investor waits for the trades to execute. As shown earlier, using Cash Secured Puts instead of Buy Limit Orders provides a better risk/return profile and is the preferred method to acquiring stock. Likewise, using Covered Calls instead of Sell Limit Orders also provides a better risk/return profile when trying to sell stock at a higher price.

Example

$XYZ is currently trading @ $100/share

Goal: To purchase $XYZ at $95/share with a target of $120

In the above example, $XYZ stock is acquired $2/share cheaper than entering a buy limit. The ideal outlook for this strategy is that the stock has a short-term retracement before continuing a longer-term rally. Investors should have a neutral/slightly bearish short-term view while having a bullish long-term view. If the strike price is not reached and there is no assignment, the investor will keep the premium received as an income. Cash Secured Puts can be rinsed and repeated each period to generate a consistent income. If the stock is acquired at $95, the investor can start selling Covered Calls which allows the investor to sell the stock after a sharp rally to maximize capital appreciation:

The investor already owns 100 shares of stock $XYZ with a current market price of $100

Goal: To sell $XYZ @ $120 after rally

Sell Sept 2019 $120 covered call @ $2

Limitations

Using both strategies allow for the investor to generate income as well as taking advantage of a sharp rally in stock price. However, there are limitations to this strategy:

• Patience is required, trades generally only execute at expiration
• Potentially miss out on some opportunities – if the price does not retrace then the investor will not be able to purchase the stock at a discount. Additionally, price could rally well above the strike price of the covered call which causes the investor to miss out on extra capital appreciation
• Requires trading in 100 share increments

‍

Best Practices and Tips

• Acquire shares at a discount using Cash Secured Puts
• Start selling covered calls immediately after acquiring shares
• Use shorter dated options to maximize time decay
• Use aggressive strikes (high delta) for cash secured puts
• Use conservative strikes (low delta) for covered calls
• Avoid selling covered calls going into earnings announcements

Summary

Deciding which strategy to use is based on the primary goal of the investor. If the goal is to simply generate income from the existing stock in the portfolio, selling Covered Calls is the best strategy. However, if the goal is to obtain the stock at a cheaper price, Cash Secured Puts provide an ideal way of doing so. If the goal is to maximize capital appreciation, both of these strategies should be used together as it allows investors to “buy low and sell high”. No matter what the end goal is, following the best practices for each strategy mentioned above and having a consistent, methodological approach will allow you to maximize the effectiveness of each strategy and enhance the yield of your portfolio!

‍